Controlling the flow? New SEC fund liquidity management rules

Peter Jones Oct 17, 2016

On October 13th the SEC approved new Liquidity Management rules for open-end mutual funds and ETF’s that are required to be in place for most funds by December 1st 2018. This may seem like a long time away, but reviewing the small print of the requirements, funds may well need all that time to get a robust system and process in place to comply.

Ian Blance

Liquidity Buckets

The new rule 22e-4 requires the implementation of a written liquidity risk management program, approved by the fund board, which includes multiple elements. The one likely to cause the biggest operational headache for funds is the requirement to classify portfolio positions into liquidity ‘buckets’. These are based on the number of days the fund reasonably expects the investment would be convertible to cash in ‘current market conditions’ without significantly changing the market value of the investment.

There are four of these liquidity buckets (2 less than the original proposal):

Highly Liquid – convertible in 3 business days or less.

Moderately Liquid – convertible between 3-7 calendar days.

Less Liquid – convertible between 3-7 calendar days but likely to settle later than that.

Illiquid – not reasonably expected to be disposed of within 7 days without significant change in value.

There is also the ability to classify positions by asset class unless ‘market, trading, or investment-specific considerations’ of a position make this unreasonable. Liquidity classifications must be reviewed at least monthly, and more frequently if any of these considerations materially change.

The rule requires a fund to take into consideration ‘market depth’ when classifying liquidity, and outlines eight factors as ‘guidelines’ for the determination:

Existence of an active market for the asset, including whether the asset is listed on an exchange, as well as the number, diversity, and quality of market participants;

Frequency of trades or quotes for the asset and average daily trading volume of the asset (regardless of whether the asset is a security traded on an exchange);

Volatility of trading prices for the asset.

Bid-ask spreads for the asset.

Whether the asset has a relatively standardized and simple structure.

For fixed income securities, maturity and date of issue.

Restrictions on trading of the asset and limitations on transfer of the asset.

The size of the fund’s position in the asset relative to the asset’s average daily trading volume and, as applicable, the number of units of the asset outstanding.

The fund board is responsible for approving the program, but in terms of day to day operation, they are able to designate an officer, or the fund’s adviser, to run this program. We do not think that this is going to be an easy task.

Data Challenges

More than anything, successfully implementing a compliant liquidity management program is going to be a huge data challenge. Without the relevant data it will not be possible to classify fund positions into the required buckets – the cornerstone of the exercise. Notable issues are:

Access to data

Key data sets that will be required include: trades and market quotes; quality and frequency of these; trading volumes; volatilities; bid/ask spreads, and; terms and conditions data. For relatively simple, exchange traded instruments, this data may be readily available (although it typically has a cost), but for OTC and more thinly traded securities such as fixed income, the issue can be more problematic.

Data management

It is not sufficient just to gain access to this data. For it to be useful in the classification process – which will likely need to be a systematic methodology to meet the ongoing review demands of all but the smallest funds – it needs to be stored and managed in such a way to make it easy to aggregate, retrieve and analyze.

Analytics

Finally, the data will need to be converted into some kind of metric or score to determine the classification bucket into which the position will be placed. As the Commission have said, they do not rule out this being at an asset class level (although the granularity of what would be acceptable here is still uncertain), unless ‘market, trading, or investment-specific considerations’ rule it out. However, market depth must be taken into account, making factor eight above a key issue.

As with valuation and pricing, it is likely that many mutual funds will resort to third party service providers as a means to comply with these new rules, and the Commission takes no issue with this. However, they clearly anticipate vendors providing assistance into a process run by the fund, rather than a fully outsourced solution, and require rigorous due diligence before engaging such a service.
To reprise our oft stated mantra, it is very much caveat emptor when it comes to the use of externally produced liquidity scores and metrics.

Conclusions & Recommendations

We believe that these new rules represent a major technical challenge to fund operations, and a significant new oversight and judgmental burden to fund boards and their advisers. We recommend:

Implement data management software and systems as a solution to storage and retrieval.

Fully document any subjectivity in interpretation or assumptions and the rationale for the choices made.

Conduct full due diligence on any third party service providers used to assist in this process. This should encompass both the specific qualities of the service, such as methodology, sources, staffing, etc. and issues like business continuity and cybersecurity, which are very much on the SEC radar.